AerCap Holdings Is A Value Investor's Dream Stock

| About: AerCap Holdings (AER)

Summary

AerCap has superior operating performance.

The aircraft leasing industry has a lot of tailwinds.

The management has strong stewardship of shareholder values.

AER is trading at a discount to my buy limit.

I. Introduction

AerCap (NYSE: AER) is the world's largest independent aircraft leasing company. By the end of December 2016, it owns 1022 aircraft, manages 124 aircraft, and have order on the book of 420 aircraft.

(from 2015 investor day presentation)

An aircraft typically has 25 years of useful life. AerCap executes transactions in all stages of the lifecycle of an aircraft after it is being manufactured:

  • Acquiring and holding a new or used aircraft for leasing purpose
  • Selling a used aircraft, usually after it has consumed ⅓ of its useful life
  • If the secondary aircraft market is not favorable, AerCap may choose to hold it longer. Through the wholly-owned subsidiary AeroTurbine, AerCap has the capability to do aircraft maintenance, and engine leasing and trading. For an aircraft that reaches the later stage of its useful life, AerCap can part it out for sale if the sum-of-parts is worth more than keeping it in operation.

Since the leasing management is highly scalable, AerCap also provides aircraft asset management to third-parties for management fee with limited incremental cost.

When comparing to peers like (NYSE:AL) and (NYSE:FLY), the age of AerCap's fleet is higher:

(from and (NYSE:AYR) 2016 Q4 releases, and 2016 Q3 releases)

Having older fleet does not necessarily means AER is inferior because that is just the result of the difference in business model. AerCap has the expertise to keep an aircraft longer to squeeze out more profits from it, which is nothing wrong with that model. Generally speaking, and have higher operating margin because of lower maintenance cost dealing with younger fleets, but has a higher return on asset and return on capital.

(from 20-Fs, 10-Ks, and quarterly releases)

(from Gurufocus)

The customer base of AerCap is diversified across the globe. Below is the sources of revenues from different regions:

(from 2015 20-F)

No single customer represents more than 7% of the total leasing revenue:

(from 2015 20-F)

II. Simple and scalable business model

AerCap has a very simple business model. It sources aircraft from manufacturers, or opportunistically through the secondary market, usually through purchase and leaseback transactions. Then, the aircraft are leased out to airlines. You can also think of it as merely in the business of providing secured financing to its customers. AerCap makes arbitrages on its relatively lower cost of capital and higher buying power due to bulk orders.

The low cost of debt is what most of AerCap's customers (e.g. airlines) can only dream about:

(from 20-Fs)

The following slide from the 2016 Investor Day presentation demonstrates how AerCap earns its spread:

Deducting rental yield by the depreciation rate, we get an approximate unleveraged return on incremental investment: 11.6% - 5.3% = 6.3%. Because AER maintains a debt to equity ratio from 2.7x to 3x, we can estimate the incremental return on equity by:

Unleveraged return + debt/equity ratio X (unleveraged return - cost of debt)

= 6.3% + 2.7 x (6.3% - 4%)

= 12.51%.

Below are the top customers of AerCap, it is not surprising the most of them are airlines outside of the North America, which generally have lower credit ratings. One of AerCap's top customer, Air France, is not even rated.

(from 2016 Investor Day Presentation)

Because the business model is not complicated and the company has been established for years, any idiots can leverage the existing experience of the company to run it. AerCap does not have to chase the next big thing, but simply does the same thing again and again. Due to AerCap's size, the highly scalable business nature allows AerCap to have the lowest management cost among its peers:

(Management cost is defined as SG&A/Total revenue, data from and 2016 Q4 releases, and 2016 Q3 releases)

III. Long track record of solid operating performance

AerCap has an excellent long tracking record. Despite occasions defaults from its customers caused income volatility in the past, AerCap has over eleven years of positive and increasing income, including the financial crisis in 2008-2009. The CAGR of EPS is 14.86%.

(from 20-Fs)

The management has done a good job on keeping utilization rate high:

(from 20-Fs)

The debt ratio has been stable for the past eleven years. A high debt ratio caused by acquisitions usually prompted deleveraging within one to two years:

(from 20-Fs and annual Q4 presentations for the years)

IV. The industry dynamics is favorable to investors

Sufficiently high barriers to entry

While providing capital is not difficult, an aircraft leasing company needs to have expertise in aircraft maintenance, understanding the supply/demand of aircraft, and global customer relationships to market its aircraft. This know-how and established customer relationships create sufficiently high barriers to entry to prevent newcomers to squeeze out the profits enjoyed by the incumbents. The health ROE of all players is a sign that the industry has rational pricing:

(from and 2016 Q4 releases, and 2016 Q3 releases)

Win/Win relationship with upstream and downstream players

Airlines love aircraft leasing companies. Without intermediaries, airlines have to place orders ahead, which results in concession on delivery time (and pay the penalties) because of overestimating the demand, or leaving profits on the table because of underestimating the demand. Aircraft leasing companies are also good buyers to take the used aircraft from the airlines. Aircraft manufacturers also love aircraft leasing companies because buyers with stable capital like AerCap can smooth out orders and deliveries.

Air traffic is growing, so the total addressable market (NYSE:TAM) is growing as well

Despite the fact that various crisis happened in the last decade, air traffic just kept growing:

(from 2016 investor day presentation)

This can be explained by the wealth effect, especially the growing middle class in less developed markets. In the near future, the air traffic is expected to keep growing, with higher growth coming from the emerging markets:

(from AL 2016 Q3 presentation)

In additional to increase in air traffic growth that brings the demand on more aircraft, there is an ongoing to trend for airlines to favor leasing vs owning:

(from 2016 investor day presentation)

The bottom line: there is no shortage of growth for the aircraft leasing industry.

Airlines are healthier than before

Historically, two things bankrupted airlines:

  1. high oil price
  2. irrational pricing

The shale revolution happened in the United States shift the production dynamics quite a bit. No longer can the oil price be determined by a few players from the oil cartel in middle east anymore. With the flexibility in changing production cost in shale oil production (take a look at this article), the boom of private shale oil production companies ensure the oil price will be kept in check by market force in the near future.

The aggressive consolidation of the airlines in the United States lessened a lot of competition in the industry, so irrational pricing is less likely to happen in the near future. Warren Buffett's $10 billion bet on airlines is proof that the airline industry will be more stable than before, which decreases default rates, and thus very favorable to the aircraft leasing industry. While the consolidations were concentrated in the US, one can easily see the same story can play out in other parts of the world.

I believe the lower default rate is far from factoring into the current aircraft leasing prices.

V. Strong stewardship of shareholder values

Since AerCap is similar to a shadow bank, its book value is a good indicator of its performance as well, and that does not disappoint us. With accretive acquisitions and opportunistic share repurchases, AerCap increased its book value rapidly. In fact, the book value grew EVERY SINGLE YEAR for the past decade, achieving CAGR of over 18%!

(From 20-Fs. I include unvested restricted stock in share counts, so the book values are lower than what were shown in the press releases.)

The track record for the return on equity and return on asset is equally impressive as well:

(data constructed from 20-Fs of the company)

Besides being competent, AerCap has the biggest reason to ensure the integrity of the management: alignment of interests. I can find at least two mechanisms from the 20-F to indicate this is true:

1. A bonus clawback clause

The Company is subject to the Netherlands' Clawback of Bonuses Act that went into effect as of January 1, 2014. Pursuant to this legislation, bonuses paid to the executive director (and other directors, as defined under the articles of association, provided they are in charge of day to day management) may be clawed back if awarded on the basis of incorrect information. In addition, any bonus that has been awarded to the executive director (and other directors, as defined under the articles of association, provided they are in charge of day to day management) may be reduced if, under the circumstances, payment of the bonus would be unacceptable. As of December 31, 2015, we did not have any directors other than the executive director who were in charge of day to day management.

2. Substantial insider stock ownership

We require our Group Executive Committee members to own Company shares having a value

equal to at least ten times their annual base salary

VI. Your rich friends are investing in AerCap as well

Famous investors invested in the company as of 2016/12/31 (from Gurufocus):

Leon Cooperman

  • 4% of the total portfolio, 5th largest holding out of 91.

Mohnish Pabrai

  • 8% of the total portfolio. Mohnish places concentrated bets and AerCap is the 4th largest holding out of seven, behind FCAU, GM, and GOOG.

David Einhorn

  • 9% of the total portfolio, 3rd largest holding out of 41

VII. Risk to watch out for

Heavy reliance on the capital market

Debt maturities are spread out, but access to capital is very crucial for the company to meet its commitment and roll over its unsecured debt. However, I do not foresee a credit crisis in the near future.

Upstream or downstream players squeezing the industry

Upstream players like Boeing or Airbus may expand their leasing programs, but due to their programs limited to mint aircraft, and their equity-light business model, I think they will not be a threat.

Airlines, especially the US airlines, are getting more profitable and their credit ratings are improving. Airlines may favor owning instead of leasing aircraft from aircraft leasing companies like AerCap. Luckily, the airline industry moves very slowly, so investors should have enough time to react.

New players entering the industry

During my research, I found that Li Ka-shing bought his way into the aircraft leasing business back in 2014. Li Ka-shing is "the Warren Buffett" of Asia. He is famous in engaging in high potential industries earlier than others, while retreating from peak industries earlier than others. His investment definitely validated that good time ahead for the aircraft leasing business, but on the other hand, it may attract other irrational copycats to enter the market as well. I would be caution about other new capital coming from China, especially Chinese conglomerates, insurance and investment companies. They may affect the competitive landscape of the industry.

Surprisingly, increasing interest rate is not a big concern

From 2016 Q4 earning transcript, CEO Aengus Kelly said,

"The first thing is that we run a hedged book, so we are not exposed to rising rates on the book of business that's written and the vast - and any lease that's placed on forward order has an automatic adjustment for any increase in interest rates. Now as we go forward, rises in rates have historically being accompanied by rises in lease rates[...]And having said that also a rising rate environment generally correlate to a better global growth environment and what we've always observed in the past, the rising rate environment generally leads to asset insulation. So as long as you're hedged, right and you're operating in a decent global economy, rising rates should not be a threat to the business."

VIII. Valuation

Absolute valuation

Given the median of AerCap's ROE is a bit more than 12%, it can reasonably justify a 10% premium on its book value. Base on its 2016 Q4 book value of $49.33, its fair value is $49.33 x 1.1 = $54.26.

I also ran a discounted cash flow analysis (DCF) to cross-check the valuation as well. In this analysis, I usually use 10-15% required return. For AerCap, I use 11% because:

  • (+) its low-risk business model
  • (-) the volatility in earnings (which arguably is an opportunity for the company to do accretive share repurchases).

For growth, I rely on the guidance given on the investor day on 2016/11/16:

Based on the management projection, next year EPS can easily reach $6. With the management projection of AerCap's growth and a 12% ROE, I assume the company will reinvest about 70% of its earnings for at least four years. After that, it will only need to re-invest 20% of its earnings at year 5 to maintain a conservative terminal growth rate of 2.4%. The remaining earnings which are not reinvested are free cash flows, which can be distributed to shareholders through share repurchases or hopefully dividends in the future. The present value of these "free cash flows" is the fair value: $57.

My buy limit is the lower of the two numbers, $54.26, so the current market price provides at least 15% discount. Having a share buyback plan in place with an aggressive buyback track record, it is unlikely the discount can get much wider from here.

Relative valuation

It is prudent to compare AER's current P/B with others to make sure we don't miss anything obvious. I use 2016 Q3 book values because AL and FLY have not announced their Q4 earnings as of 2017/02/22:

(from Q3 releases of the companies)

Their credit ratings, debt/book ratio, and ROE pretty much explained the difference in P/B.

(credit ratings are from S&P and Moody's, not all the companies have S&P credit rating and I simply translate the Moody's ratings into S&P's)

While AL has a higher credit rating than AER, you would pay a lot for that privilege, given that both of them have an investment grade. AYR, despite its lower leverage, has significantly lower ROE, so it is weird to me it has higher P/B than AER. Based on the table above, I believe AER is at least trading at a discount compared to its peers.

IX. The bottom line

AerCap is a perfect dream stock for Buffett-style investor:

  • In an industry that 1) has sufficiently high barriers to entry, 2) is moving slowly, and 3) has a simple business model
  • Track record of stable operating margin, stable profit margin, 10+% ROE
  • Track record of increasing revenues, earnings, and book values
  • The management has strong stewardship of shareholder values
  • Trading at a discounted to a conservative fair value.

It is a strong buy at the current price, folks.

Disclaimer: I am not a licensed investment adviser. As I have no knowledge of individual investor circumstances, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended. This article is for my personal opinion sharing and for informational purposes only - any opinion expressed in this article and elsewhere on the internet is not a form of investment advice provided to you. I use information in my articles I believe to be correct at the time of writing them, which information may or may not be accurate and may or may not be up-to-date. I am not liable for any losses suffered by any party because of any information published on this article. Beware, past performance is not a guarantee of future performance.

Disclosure: I am/we are long AER.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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